Gift Loans and Taxes

Gift loans allow friends and family to provide financial assistance in order for someone to buy a home, receive personal financing or otherwise meet financial obligations. The IRS considers all borrowed money a source of income. However, since it is repaid with interest, the IRS does not collect taxes on the income. This is not true, though, if the interest charged does not equal or surpass the equity earned as a result of the loan. Since this is the case with most gift loans, special tax treatment applies.

Forgone Interest on Gift Loans

For any loan between $10,000 and $100,000, forgone interest is transferred back to the lender. Forgone interest is the sum that would be charged by a normal lender minus the sum the gift lender is charging. For example, if a father loans $100,000 to his son interest free, the forgone interest may be around $5,500. This is the amount of interest the son would have paid had he taken the loan from a banker charging the national average. This is transferred back to the lender and counted as a taxable gift for the year. On an annual basis, $10,000 of taxable gifts are excluded from taxes. The only exception to forgone interest being applied as a taxable gift comes if the borrower's income is below $1,000. In this case, the forgone interest is treated as zero.

Further, the borrower may be subject to taxation on the amount he or she has received. For a term loan, the amount you receive is considered a cash payment like a dividend. The amount is calculated by taking the loan amount, subtracting the present value and assessing the current national prime rate.

Loans under $10,000

If a gift loan is under the $10,000 threshold, borrowers and lenders do receive a great deal of relief. There is no tax treatment on the loans unless they are used to purchase an income-producing asset or if the loan is given instead of compensation to an employee. Interest payments from the borrower to the lender in a loan under $10,000 may be exempt from federal income tax depending on the loan structure.

Gift Loans for a Home Purchase

When the credit market slows down, many individuals look to family members in order to gain financing for a home purchase. It is important to understand the regulations determining the taxation of funds used to purchase real estate. It is key to make a distinction between a gift and a gift loan in this situation. If the money is being provided as a gift, the giver should detail this in writing and file a gift tax return. It is important to list the name of the individual to whom the gift was given. This could be, for example, only one of the two members of a marriage.

With a loan, it is important to have a legal document detailing the loan agreement and interest rates. Remember: the lender may be subject to a gift tax if he or she does not charge interest in a high enough amount. Charging interest, though, can generate income taxes. The cheaper option should be used.

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